Economics Links

‘There is no magic money tree’, said Theresa May on several occasions during the 2017 election campaign. The statement was used to justify austerity policies and to criticise calls for increased government expenditure.

But, in one sense, money is indeed fruit of the magic money tree. There is no fixed stock of money, geared to the stock of gold or some other commodity. Money is created – as if by magic. And most of broad money is not created by government or the central bank. Rather it is created by banks as they use deposits as the basis for granting loans, which become money as they are redeposited in the banking system. Banks are doing this magic all the time – creating more and more money trees as the forest grows. As the Bank of England Quarterly Bulletin explains:

Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

However, most of the country’s MPs are unaware of this process of money creation. As the linked Guardian article below states:

Responding to a survey commissioned by Positive Money just before the June election, 85% were unaware that new money was created every time a commercial bank extended a loan, while 70% thought that only the government had the power to create new money.

And yet the role of money and monetary policy is central to many debates in Parliament about the economy. It is disturbing to think that policy debates could be based on misunderstanding. Perhaps MPs would do well to study basic monetary economics! After all, credit creation is not a difficult topic.

What is the relationship between government spending and broad money supply (M4 in the UK)?

Why is there no simple money multiplier whereby total broad money supply is a simple and predictable multiple of narrow money?

What determines the relationship between money supply and real output?

Does it matter what type of lending is financed by money creation?

Comment on the statement: “The argument marshalled against social investment such as education, welfare and public services, that it is unaffordable because there is no magic money tree, is nonsensical.”

Could quantitative easing be used to finance social investment? Would there be any dangers in the process?

The US Federal Reserve, like many other central banks, engaged in massive quantitative easing in the wake of the financial crisis of 2007/8. Over three rounds, QE1, QE2 and QE3, it accumulated $4.5 trillion of assets – mainly government bonds and mortgage-backed securities (see chart below: click here for a PowerPoint). But, unlike its counterparts in the UK, the eurozone and Japan, it has long ceased its programme of asset purchases.. In October 2014, it announced that QE was at an end. All that would be done in future would be to replace existing holdings of assets as they matured, keeping total holdings roughly constant.

But now this policy is set to change. The Fed is about to embark on a programme of ‘quantitative tightening’, already being dubbed ‘QT’. This involves the Fed reducing its holdings of assets, mainly government bonds and government-backed mortgage-related securities.

This, however, for the time being will not include selling its holding of bonds or mortgage-backed securities. Rather, it will simply mean not buying new assets to replace ones when they mature, or only replacing part of the them. This was discussed by the 75 participants at the joint meeting of the Federal Open Market Committee (FOMC) and Board of Governors on 14–15 March.

As the minutes put it: “Many participants emphasized that reducing the size of the balance sheet should be conducted in a passive and predictable manner.”

A more active form of QT would involve selling assets before maturity and thus reducing the size of the Fed’s balance sheet more rapidly. But either way, reducing assets would put downward pressure on the money supply and support the higher interest rates planned by the FOMC.

The question is whether there is enough liquidity elsewhere in the system and enough demand for credit, and willingness of the banking system to supply credit, to allow a sufficient growth in broad money – sufficient, that is, to support continued growth in the economy. The answer to that question depends on confidence. The Fed, not surprisingly, is keen not to damage confidence and hence prefers a gradualist approach to reducing its holdings of assets bought during the various rounds of quantitative easing.

Seven years ago (on 5 March 2009), the Bank of England reduced interest rates to a record low of 0.5%. This was in response to a deepening recession. It mirrored action taken by other central banks across the world as they all sought to stimulate their economies, which were reeling from the financial crisis.

Record low interest rates, combined with expansionary fiscal policy, were hoped to be enough to restore rates of growth to levels experienced before the crisis. But they weren’t. One by one countries increased narrow money through bouts of quantitative easing.

But as worries grew about higher government deficits, brought about by the expansionary fiscal policies and by falling tax receipts as incomes and spending fell, so fiscal policy became progressively tighter. Thus more and more emphasis was put on monetary policy as the means of stimulating aggregate demand and boosting economic growth.

Ultra low interest rates and QE were no longer a short-term measure. They persisted as growth rates remained sluggish. The problem was that the higher narrow money supply was not leading to the hoped-for credit creation and growth in consumption and investment. The extra money was being used for buying assets, such as shares and houses, not being spent on goods, services, plant and equipment. The money multiplier fell dramatically in many countries (see chart 1 for the case of the UK: click here for a PowerPoint) and there was virtually no growth in credit creation. Broad money in the UK (M4) has actually fallen since 2008 (see chart 2: click here for a PowerPoint), as it has in various other countries.

Some indication that the ’emergency’ was coming to an end occurred in December 2015 when the US Federal Reserve raised interest rates by 0.25 percentage points. However, many commentators felt that that was too soon, especially in the light of slowing Chinese economic growth. Indeed, the Chinese authorities themselves have been engaging in a large scale QE programme and other measures to arrest this fall in growth.

Although it cut interest rates in 2009 (to 1% by May 2009), the ECB was more cautious than other central banks in the first few years after 2008 and even raised interest rates in 2011 (to 1.5% by July of that year). However, more recently it has been more aggressive in its monetary policy. It has progressively cut interest rates (see chart 3: click here for a PowerPoint) and announced in January 2015 that it was introducing a programme of QE, involving €60 billion of asset purchases for at least 18 months from March 2015. In December 2015, it announced that it would extend this programme for another six months.

The latest move by the ECB was on March 10, when it took three further sets of measures to boost the flagging eurozone economy. It cut interest rates, including cutting the deposit rate paid to banks from –0.3% to –0.4% and the main refinancing rate from –0.05% to –0%; it increased its monthly quantitative easing from €60 billion to €80 billion; and it announced unlimited four-year loans to banks at near-zero interest rates.

With the UK and eurozone economies in recession and with business and consumer confidence low, the Bank of England and the ECB have sprung into action.

The ECB has cut its main refinancing rate from 1% to an all-time low of 0.75%. Meanwhile, the Bank of England has embarked on a further round of quantitative easing (QE). The MPC voted to inject a further £50 billion through its asset purchase scheme, bring the total to £375 billion since QE began in March 2009.

And it is not just in Europe that monetary policy is being eased. In Australia and China interest rates have been cut. In the USA, there have been further asset purchases by the Fed and it is expected that the Japanese central bank will cut rates very soon, along with those in Korea, Indonesia and Sri Lanka.

But with consumers seeming reluctant to spend and businesses being reluctant to invest, will the new money in the UK and elsewhere actually be lent and spent? Or will it simply sit in banks, boosting their liquidity base, but doing little if anything to boost aggregate demand?

And likewise in the eurozone, will a 25 basis point reduction in interest rates (i.e. a 0.25 percentage point reduction) do anything to boost borrowing and spending?

It is like pushing on a string – a term used by Keynesians to refer to the futile nature of monetary policy when people are reluctant to spend. Indeed the evidence over the past few years since QE started is that despite narrow money having risen massively, M4 lending has declined (see chart).

Questions

What advice would you give politicians around the world seeking to boost consumer and business confidence?

Are we witnessing “The twilight of the central banker”? (See The Economist article above.)

Explain the following extracts from the Martin Wolf article: “In a monetary system, based on fiat (or man-made) money, the state guarantees the money supply in the interests of the public. In normal times, however, actual supply is a byproduct of lending activities of banks. It is, in brief, the product of privately operated printing presses… In the last resort, the power to create money rests properly with the state. When private sector supply is diminishing, as now, the state not only can, but should, step in, with real urgency.”

Should monetary policy in the UK be combined with fiscal policy in providing a stimulus at a time when the government can borrow ultra cheaply from the Bank of England? Does this apply to other governments around the world?

Figures released by the Bank of England show that M4 fell by 5.0% in the year to March 2012. This record fall comes despite over £320 billion of assets purchased by the Bank under its quantitative easing programme. These are funded by the creation of reserves in the Bank of England. (See the Bank of England site for details of the timing and amounts of QE.)

One problem with using figures for changes in M4 to gauge economic activity is that they include intra-financial sector transactions – transactions between ‘other financial corporations’ (OFCs). Such transactions do not impact on the real economy. For this reason, the Bank of England prefers to focus on a measure that excludes these transactions between OFCs, a measure known as ‘M4 excluding intermediate OFCs’. This measure rose by 2.7% in the year to March 2012. Although this was positive, it was still weak.

So why does quantitative easing seem to be having such a small effect on bank lending? The following articles look at the issue.